What is pension tax relief?

Every pound you pay into a private pension scheme is matched with tax relief by the government – effectively any income tax you have paid on that pound is paid into your pension fund. This means that for every £80 a basic rate tax payer puts into a pension scheme, the government pays £20.

Even those who don't pay tax but are still contributing to a pension (maybe because their partner is providing the money) can still receive tax relief at 20% on contributions up to £2,880 a year: the government tops this amount up to a total of £3,600.

If you are a higher rate tax payer, you can claim additional tax relief through your self assessment return. The relief ranges from 1% to 20% more, depending on how much you earn above the higher rate tax band and how much you contribute to your pension. If some of your contribution comes from earnings that have been taxed at 40%, then you will get 40% tax relief, But if some comes from the 20% tax band, you will get the lower rate of relief on that part.

Likewise, the highest rate taxpayers who pay 50% income tax on the top slice of their earnings – anything over £150,000 – can benefit from between 1% and 30% additional tax relief.

You can put 100% of your annual earnings in a pension if you can afford it, and will receive tax relief on up to £50,000 of contributions in the current tax year, meaning someone earning £200,000 would receive £25,000 from the government towards their pension.

What is the purpose of tax relief?

The aim of tax relief is to encourage people to invest more towards their retirement and rely less on the state for income after they stop working. Those who receive below a certain threshold in pension income – currently £137.35 if you are single or £209.70 if you have a partner – receive a top up through a means-tested benefit called pension credit. The more people that save for themselves, the fewer who will need to claim pension credit.

Why change things?

The amount of tax relief paid by the government has nearly doubled in the last decade, from £17.6bn in 2001-02 to £32.9bn in 2010-11.

In the last few years the proportion paid to higher-rate taxpayers has also increased because the government has frozen the tax band thresholds, thereby driving up the number of higher rate tax payers.

Ten years ago there were 3 million higher rate tax payers – 10.5% of the 28.6 million taxpayers, according to David Heaton, employee benefits partner at accountants Baker Tilly. Now there are more than 4 million people – 13.3% of the 29.9 million taxpayers in the 40% and 50% bands, and this figure will rise again in April when the 40% threshold is frozen again at £42,475.

In 2009-10, 18% of the pension tax relief went to those earning £150,000 or more, while a further 16% went to those earning £75,000 to £149,999.

None of these people should need to draw on state benefits in retirement, so there is less need to "bribe" them with such generous tax relief.

The government is also reported to be looking for savings so that it can abolish the 50% rate of tax.

So what is being considered for the budget, according to the rumours?

Speculation surrounds cutting of the tax relief received by those earning £150,000 or more: the most commonly mooted idea is a reduction in the level of relief such investors get to 20%.

However the Centre for Policy Studies will recommend in a report published on 9 March that higher rate tax relief should be abolished altogether. Some £3bn of the £7bn saved through this measure could be used to re-instate the 10p dividend tax credit abolished by Gordon Brown in his first budget in 1997. The thinktank also suggests removing the option of taking out 25% of your pension fund as a tax free lump; instead investors would get a 5% top up to their pension pot just before they use the money to buy an annuity. That would be of much more lasting benefit to all pension investors – not just the extremely wealthy ones – and the thinktank says it would be cost neutral.

Would this work?

Not according to pensions expert Tom McPhail of independent financial adviser Hargreaves Lansdown. He says that if the higher rate of tax relief is abolished, investors will simply opt for "salary sacrifice" instead. This is where you ask your employer to pay money into your pension instead of receiving a higher salary. The payments would be gross – with no tax payable – and therefore equivalent to their marginal rate of tax.

He also says that continual tinkering with pension rules by successive governments could deter people from investing in pensions. He points to evidence from New Zealand where investors opted out of the government sponsored scheme Kiwisaver, citing two system changes in five years as a reason not to trust the savings scheme or the government in the long run. "Governments meddle at their peril," he said.